Fed on hold, with more questions than answers

Only limited adjustments seen to statement

WASHINGTON (MarketWatch) -- The Federal Reserve is likely to hold its overnight interest rate target steady for the seventh straight meeting Wednesday, as the central bank is patiently waiting to see whether its forecast of a second-half pickup proves correct.

"The Fed is stuck on hold," said Steve Stanley, chief economist at RBS Greenwich Capital.

Economists are unanimous in their expectation that the Fed will choose to hold rates steady, and say that leaving rates at 5.25% has been telegraphed by senior Fed officials in recent speeches.

'The Fed remains stuck between soft growth on one side and high inflation on the other, and until there is some break on one side or the other of that contrast, they are going to definitely remain on hold.'
Steve Stanley, RBS Greenwich Capital

"Fed officials have consistently indicated that there are high hurdles to changing monetary policy in either direction," said Richard Berner, economist at Morgan Stanley, in a note to clients.

Economists at Goldman Sachs said the Fed would hold rates steady until three things are clear: whether weakness in the April nonfarm payroll report is the start of a trend; if the factory sector is rebounding or sputtering; and whether consumer spending will be hit by high prices at the pump.

"Pending answers to these questions, there is no reason to expect any material change from this week's FOMC meeting," said Goldman Sachs.

The Fed is also closely watching the trajectory of the housing sector, economists noted.

Fed officials are seen as likely to make only limited word changes to the policy statement issued at the end of the meeting, unwilling to create more confusion after the stir caused by the major changes in the March 21 statement.

"It feels like the best strategy for them is just to leave it [the statement] alone, unless they really wanted to dramatically change the message that they are sending," said RBS Greenwich Capital's Stanley.

In the six weeks since the last FOMC meeting, there are now greater risks that recent economic weakness could gather momentum. First-quarter GDP growth was a paltry 1.3%, and the second quarter is starting out feeling almost as weak. See complete coverage of Fed and economy

But at the same time, there is a greater risk that core inflation will not gradually decline. Despite a year of 2% GDP growth or less, core PCE inflation has remained stubbornly above the Fed's 1-2% comfort zone.

"The Fed remains stuck between soft growth on one side and high inflation on the other, and until there is some break on one side or the other of that contrast, they are going to definitely remain on hold," said Stanley.

Despite the bewitching data, the Fed still expects the economy to gradually recover in the second half of the year, and so will be patient with monetary policy, said economists Mickey Levy and Peter Kretzmer of Bank of America.

The FOMC moved to give itself greater flexibility in the language of its March 21 policy statement, removing language that had the only option for policy as a rate hike.

In its place, the FOMC said that "future policy adjustments will depend on the evolution of the outlook of both inflation and economic growth, as implied by incoming information." Read text of FOMC's March 21 statement

Confined to tinkering

Economists at Goldman Sachs said the changes in the Wednesday policy statement will be confined to "tinkering" with the description of recent economic events.

Economists are sharply divided about whether the next Fed move will be a rate cut or tightening. The majority of economists see the Fed modestly easing rates, although the timing is uncertain.

Paul Brewbaker, chief economist at the Bank of Hawaii, believes the Fed will ease at its Aug. 7 meeting and gradually lower rates to 4.25% by January.

On the other hand, Stanley of RBS Greenwich Capital believes the next move will be a rate hike.

"Our view is that the most likely change is that growth is going to pick up as the year wears on and with inflation remaining high and the unemployment rate remaining very low. We think that, ultimately, the next move is going to be a tightening," Stanley said.

Any move before August is unlikely, economists said, because Fed officials will not get final readings for the second quarter or initial readings on third quarter.

In an interview with MarketWatch, former Fed governor Ed Gramlich said he believes the biggest risk facing the central bank is that the economy could quickly lose momentum and the Fed will find itself waited too long to cut rates.

Gramlich said he didn't see much risk of inflation gathering momentum.

In general, Gramlich said the next Fed move depends on the data. "When they said the next move depends on the data, they mean that. They're not being artful," Gramlich said.

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